Why office properties and which ones? Part 2

John Greenman

Letter from Denver

This is Part 2 of a two-part series to point out why investors of all types tend to like office properties and, for private (high net-worth) investors, offer office building selection criteria.

In Part 1, we explained why funds focused on total returns and institutional investors will want sizeable portfolio allocations to office properties. In this second part, we focus on selection criteria for private (high net worth) investors. Criterion number one is of course location.

Good macro fundamentals

As for all commercial real estate, when seeking office property, private investors should first seek out cities with good macroeconomic fundamentals. We selected all the Southwestern U.S. cities we monitor closely at TransEconomics precisely on this basis.

The right size

Second, the property size must match the investor’s equity capacity. Many of the smaller suburban assets do match the equity capacity of private investors.

Quality location

Third, one must sift carefully through the many available investment options to find those offering the best-quality locations. Most of the office assets in our favorite Southwestern U.S. cities are located in suburban submarkets and more precisely within mature infill “micro-markets” offering a wide range of amenities important to today’s office tenants—including the widest possible variety of transit options.

The right roll rent composition

Finally, to maximize the ability to generate both a steady cash return and the potential for long-term value appreciation, private investors must look at rent roll composition. We prefer buildings whose tenants come from a wide range of industries, with lease expiries staggered over a number of years, and a large enough number of tenants so that none dominates the rent roll and hence the economics of the property.

Tenant diversity is important to avoid undue exposure to a “meltdown” in one particular type of business, as landlords who had high concentrations of residential real estate firms in their buildings learned to their sorrow when the subprime mortgage business collapsed in 2007–2008.

Likewise, having leases that expire gradually and in an orderly fashion rather than “bunched” in a single year or two avoids the risk of re-setting the entire rent roll to a lower rent level if the lease renewal negotiations happen to fall during a period of weak market demand.

Finally, limiting exposure to any one single tenant to, ideally, no more than 20% of the entire rent roll ensures that the loss of such tenant does not imperil the entire property. Most well-occupied properties can withstand the loss of 20% of income and still stay current on debt service payments. Buildings occupied by only one or two big tenants are best left to institutional owners, who are better able to bear the costs of re-tenanting in the event of vacancy.

Next step: management efficiencies

By taking care to select the right rent rolls after first working “from the top down” in terms of positive regional macroeconomics and quality of location of the asset, private investors indeed can make a good long-term investment in the office sector. Their next step will be to increase management efficiencies by adding similar properties nearby—in other words, create a portfolio.